UNIVERSITY OF ATHENS Department of Economics PUBLIC FINANCE. gkaplanoglou public finance

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1 UNIVERSITY OF ATHENS Department of Economics PUBLIC FINANCE 1

2 Instructor Georgia Kaplanoglou Office: 1, Sofokleous street, Sixth floor, office no. 605 Office hours: Friday, Tel: Class-Website. 2

3 LECTURE 1 Government and the Economy 3

4 Role of the Government in the Economy 4

5 Roles of Government in the Economy In the Wealth of Nations, Adam Smith enumerated four justifiable functions of government: 1. the duty of protecting the society from violence and invasion by other independent societies; 2. the duty of protecting every member of society from injustice and oppression of every other member of society; 5

6 Roles of Government in the Economy 3. the duty of establishing and maintaining those highly beneficial public institutions and public works which are of such a nature that the profit they earn could never repay the expense to the individuals to provide them and which it, therefore, cannot be expected that they would be supplied in adequate quantities; and 4. the duty of meeting expenses necessary for support of the sovereign 6

7 Definition of Public Finance Public Finance the field of economics that analyzes government taxation and spending policies Public Sector Economics Public Economics What is not part of public finance 7

8 Definition of Public Finance Public Finance deals with the taxing and spending activities of various governmental units. However, the resources for all government expenditures ultimately come from the private sector. So, public sector decisions affect private sector decisions in many ways both large and small. The overall impact of public sector decisions must be examined in the context of their impact on private sector behavior. 8

9 Government as a Decision Unit Public finance studies the economic activity of the government as a unit. In studying this unit, in some sense, we treat it as analogous to a person. For example in studying the economic activity of a person we would want to know how the person earns his/her income and how much the person earns. how the income is spent. how the individual makes decisions or choices among alternatives. 9

10 Government as a Decision Unit Similarly, in studying the public economy, we want to know how factually the government secures its revenues -- both process and amounts --. how the revenues are spent. how the government makes decisions or choices among alternatives.. Here the analysis becomes very complicated because, while for an individual we are examining a single mind, for governmental decisions we are looking at a collective mind or political process. Moreover, an individual s decision is one among many decisions, government decisions can impact the behavior of many individuals. 10

11 The Field of Public Finance Public Finance is the area of economic theory devoted to the study of how government policy -- tax and expenditure policy-- affects microeconomic behavior as well as aggregate economic activity. Public finance does not concentrate on financial arrangements of government but on the economic consequences of public policy on Resource allocation: Allocation Income distribution: Distribution Level of economic activity: Stabilization 11

12 ALTERNATIVE VIEWS OF GOVERNMENT S ROLE IN SOCIETY Organic view of government Mechanistic view of government 12

13 Organic view of government Society is conceived of as a natural organism. Each individual is a part of this organism, and the government can be thought of as its heart and mind. 13 Historically, it has taken extreme forms such as national socialism in Germany in the interwar years. Individualism is subservient to the natural goals of the state. Government as a utility maximizing entity or government as a ruling clique.

14 Organic view of government For example, Yang Chang-chi, Mao Tse-tungs, ethics teacher, states that A country is an organic whole just as the human body is an organic whole. It is not like a machine which can be taken apart and put together again. The individual has significant only as part of the community and the good of the individual is defined with respect to the good of the whole. In the organic approach, the community is stressed above the individual. 14

15 Mechanistic view of government The government is not part of the social machine. It is a contrivance -- another machine-- created by individuals to better achieve their individual goals. The individual rather than the group is at the center of the system. (Government as a democratic process) 15

16 Legal Framework of Public Finance Political Institutions constitute the rules and generally accepted procedures that evolve in a community for determining what government does and how government outlays are financed 16

17 Legal Framework of Public Finance Greek Constitution Public Expenditures Public Revenues Local Governments 17

18 GROWTH OF GOVERNMENT To what extent are society s economic resources controlled by the public sector? Has this control over resources been growing over time? 18

19 Growth of government 19

20 TOTAL GOVERNMENT OUTLAYS AS PERCENTAGE OF GDP Euroarea Greece 40 OECD Source: OECD Historical Statistics

21 General Government Revenues % GDP Greece OECD Euroarea

22 General Government expenditure, % of GDP 22 Καπλάνογλου

23 23 General government expenditure, per head

24 24 Public Investment, % of government expenditure

25 Revenues-Expenditures Fiscal balance % GDP Average Germany Greece Ireland Italy Portugal Spain Sweden United States1 Euro area Total OECD Revenue Expenditure Balance 25

26 26 Percent of women in minister / deputy minister positions

27 Public sector pay, as a % of GDP 20,8 13,8 NLD KOR JPN NZL EST CZE AUS DEU ISR CAN SVK FIN GBR SWE ISL OECD (UWA) OECD (WA) LUX HUN POL NOR FRA USA AUT BEL DNK CHE ESP IRL SVN MEX ITA PRT GRC COL LVA RUS % as percentage of GDP 5 0 0

28 Government Debt % GDP Belgium 123,2 119,7 95,9 91,7 88,1 93,3 100,5 100,7 France 70,3 66,8 75,7 70,9 72,3 77,8 89,2 94,1 Germany 62,2 61,5 71,2 69,3 65,3 69,3 76,4 87,0 Greece 97,7 101,5 121,2 115,6 112,9 116,1 131,6 147,3 Ireland 62,1 51,2 32,6 28,8 28,8 49,6 71,6 102,4 Italy 132,6 126,4 120,0 117,4 112,8 115,2 127,8 126,8 Portugal 63,3 60,5 72,8 77,6 75,4 80,6 93,1 103,1 Spain 75,3 69,4 50,4 45,9 42,1 47,4 62,3 66,1 USA 64,2 60,5 61,4 60,8 62,0 71,0 84,3 93,6 Euro area 81,5 78,1 78,1 74,5 71,6 76,5 86,9 92,7 Total OECD 74,2 72,5 76,3 74,5 73,1 79,3 90,9 97,6 28

29 Explanations for the Size and Growth of Government Dennis Mueller in The Growth of Government list five explanations for public sector growth. 1. The government as provider of public goods and eliminator of externalities 2. The government as redistributor of income and wealth 3. Interest groups as a cause of government growth 4. Bureaucracy as a cause of government growth 5. Fiscal Illusion 29

30 Some explanations on the growth of the public sector Law of Ever Increasing State Activities Wagner s Law Engel s Law Baumol Unbalanced Growth Model Displacement, Inspection, and Concentration Effect Critical Limits Hypothesis Theory of Bureaucracy 30

31 Wagner s hypothesis of increasing state activities As per capita income and output grow in industrialized countries, the public sector of these countries necessarily grow as a proportion of aggregate economic activity. Wagner indicated this was a natural law of ever increasing state activity. Why? 31

32 Wagner s hypothesis of increasing state activities Economic growth and social progress lead to an increase in governmental functions. The increase in necessary functions leads to pressure for absolute and relative growth of government activities What functions? 32

33 Wagner s hypothesis of increasing state activities 33 Provide Law and Order: The need to provide a stable framework for economic activity. Greater economic growth or industrialization leads to greater labor specialization causing increased complexities (e.g., in the contracting process) and interdependencies in economic and social life. Greater interdependencies foster the need for government resolution of conflicts and the need to maintain continually more specialized services ( e.g. regulating derivative financial claims and mediate cultural conflicts as well).

34 Wagner s hypothesis of increasing state activities Need for Government Participation in the Production of certain Goods and Services produce public and quasi-public goods For example, Goods requiring large fixed investment: infrastructure projects Natural monopolies and externalities Communications, education, and banking / payments industries Goods with a degree of publicness 34

35 Wagner s hypothesis of increasing state activities Per capita output of public goods (Consumption of Public Goods) Engel Curve for Public Goods pg 2 High Income Elasticity Low Income Elasticity Real per capita income (Income) 35

36 Wagner s hypothesis Per capita output of public goods Subsistence Stage Falling Relative Public Sector First Wave Society Wagner s Law Period of Industrialization Rising Relative Public Sector Second Wave Society Post-Industrialization Falling Relative Public Sector pg 1 pg 2 Third Wave Society Society resists to a large public sector: Cultural preferences for market activity; Individual Freedom Per Capita Real Income

37 Baumol s Theory of Unbalanced Growth 37 Public sector expenditures will tend to grow faster than the rest of the economy. All economic activity can be grouped into two categories those that are technologically progressive and those that are not. Output per worker is greater in one sector than the other, however, the wage tends to be the same. Thus, unless labor markets are sealed off, cost in the less productive have to rise. If market demand is inelastic or if there is a strong political demand for the goods in the less productive sector then labor will shift to this sector and the level of expenditures in this sector will rise.

38 Baumol s Theory of Unbalanced Growth 38 To the extent that the public sector is the less productive sector, expenditures in the sector will rise relative to the private sector. That is, if we assume: a low price elasticity for government services improvements in productivity as more likely in the private than public sector Relatively uniform wage rates between the public and private sectors Then, it would be reasonable to expect that cost would rise in the public sector relative to the private sector and that governmental expenditures would rise at a faster rate than the GDP.

39 Peacock and Wiseman Approach to Growth of the Public Sector The relative growth of the public sector is steplike rather than continuous. 39

40 Peacock and Wiseman Approach to Growth of the Public Sector Public Sector Revenues and Expenditures as a % of GDP New fiscal plateau Increase due to social disturbance Time 40

41 Peacock and Wiseman Approach to Growth of the Public Sector DISPLACEMENT EFFECT: War and depression create a displacement effect by which previous (lower) tax and expenditure levels are replaced by new higher budgetary levels. New levels of tax tolerance (deficit tolerance ) support a new fiscal plateau where tax burdens are higher. On the new plateau some old expenditures by government are eliminated and new ones are substituted for them. Some of the substitutes may have been produced by the private sector in the past. Perhaps R&D or retirement benefits. 41

42 Peacock and Wiseman Approach to Growth of the Public Sector INSPECTION EFFECT: War and other social disturbance force people and their government to seek solution to important problems which previously had been neglected or perhaps unnoticed. For example, the need for an interstate highway system or re-engineering of the hospital system. 42

43 Peacock and Wiseman Approach to Growth of the Public Sector CONCENTRATION EFFECT: This effect notes the tendency for central government economic activity to become an increasing proportion of total public sector economic activity when a society is experiencing economic growth. 43

44 Clark s Approach to the Growth of the Public Sector: CRITICAL LIMITS HYPOTHESIS The critical limits of public economic activity is set by the rate of inflation. The critical limit hypothesis as originally expressed is that inflation necessarily occurs when the government sector, as measured in terms of taxes and other receipts, exceeds 25 percent of aggregate economic activity. 44

45 Clark s Approach to the Growth of the Public Sector BASIS OF THE HYPOTHESIS When taxes collected by the government reach the critical limit of 25 percent, incentives are harmed and people become less productive; thus aggregate supply is reduced. People become less resistant to various inflationary means of financing government; thus aggregate demand is increased. The diagram below illustrates the implications of this conclusion. 45

46 Price Level Clark s Approach to the Growth of the Public Sector AS 1 P 2 P 1 AD Q 1 Quantity

47 Government Bureaucracies As Mueller notes government bureaucracies are an independent force explaining the growth of the government sector. (Peacock-Wiseman Approach) Empirical studies in this area have usually reasoned as follows. The larger the bureaucracy, the more difficult it is for outsiders to monitor its activity, and the more the insiders there are who are working to increase the size of the bureaucracy. Thus the growth of bureaucracy is likely to depend on its absolute size. 47

48 Government Bureaucracies Studies have found that growth in the size of a bureaucracy's budget is expected to increase with the absolute size of the budget. As Mueller indicates this result is broadly consistent with the pattern of growth of government expenditures observed in many countries over the past two centuries: slow but steady initial growth, gradually shifting into more rapid rates of growth. 48

49 Government Bureaucracies The idea that bureacracatic power increases the size of government presumes that the bureaucracy can deceive the legislature about the true costs of supplying different levels of output. 49

50 Fiscal illusion The fiscal illusion presumes that the legislature can deceive the citizens about the true size of government. The fiscal illusion explanation for the growth in the size of government assumes that citizens measure the size of government by the size of their tax bills. 50

51 Fiscal illusion To increase the size of government beyond what people want, the tax burden has to be disguised so as to create an illusion that the government is smaller than it actually is and so the government can grow beyond the level citizens prefer. The fiscal illusion has been empirically tested in various forms. 1. A tax structure is more difficult to judge the more complex the tax structure. 2. Renters are less able to judge their share of property taxes in the community than are homeowners. 51

52 Fiscal illusion 3. The implicit future tax burdens inherent in the issuance of debt are more difficult to evaluate than equivalent current taxes. 4. Built-in tax increases because of the progressivity of the tax structure are less clearly perceived than are legislated changes. Mueller, quoting a review of the empirical literature by Oates, concludes that the fiscal illusion provides plausible hypotheses, none of which have very compelling empirical support. 52

53 Expansion of suffrage: redistribution factor Meltzer and Richard suggest that one explanation for the secular growth in government around the world over the past two centuries has been expansion of suffrage. Those added to the voting rolls are more often than not those with incomes and productivity below the median. Thus the median voter changes to someone more prone toward the redistribution of income by the government. 53

54 Expansion of suffrage: redistribution factor Meltzer and Richard gave increased inequality of income as well as increased suffrage as the primary causes for the growth of government and presented some empirical support for their hypothesis. Peltzman has also presented an explanation for the growth of government that depends on the shape of the distribution of income. Peltzman did not however makes use of the median voter theorem in developing the argument. 54

55 Expansion of suffrage: redistribution factor Rather, he envisioned a form of representative government in which candidates competed for votes by promising to redistribute income for those voters or groups of voters that agreed to join the candidates coalition of supporters. Peltzman reasoned that the more equal the distribution of income among the potential supporters of the candidate, the more bargaining strength they would have. 55

56 Expansion of suffrage: redistribution factor Thus the candidate must promise a greater amount of redistribution the more equal is the initial distribution of income among voters Peltzman pointed to the spread of education as an important factor increasing the equality of pre-transfer incomes and thus leading to a growth in the size of government. 56

57 Expansion of suffrage: redistribution factor What about redistribution? Mueller concludes that it is difficult to suppress the impression that an important component of the explanation for the growth of government lies in government s redistribution activities, so substantial has been the growth in the transfer component of government budgets. However, to explain the growth of government in simple redistributional terms is inadequate. 57

58 INTEREST GROUPS Mueller and Murrell presented empirical evidence that interest groups effect the size of government. They described a political process in which parties supply interest groups with favors in exchange for the interest groups support. 58

59 INTEREST GROUPS When these favors take the form of goods targeted to specific interest groups, but with spillovers for other groups, government grows larger. The number of organized interest groups in a country was shown to have a positive and significant effect on the relative size of the government sector in a cross sectional sample of OECD countries. 59